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Flow control: Sector at a crossroads?

The sector’s performance has plateaued in recent years. But flow control’s best days may still be ahead, given increasing demand and technological advancements.

The flow control sector, which is part of the broader industrials sector, consists of companies that provide products or services involving the management and control of liquids and gases. Such products include pumps, valves, compressors, meters, filtration products, and other related equipment. These are some of the most critical and prevalent components in modern industries. Comprising three core segments—flow handing, flow management, and specialty equipment—the sector represented a global market worth $225 billion in revenue in 2017 (Exhibit 1) and has outperformed the broader industrials sector over the past 15 years.

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However, performance has plateaued in recent years, and as the flow control sector looks to the future, it finds itself at a crossroads. Has the sector’s performance reached a ceiling? Or can it leverage favorable secular trends of rising demand for infrastructure driven by rapid urbanization in emerging markets and an overhaul of aging infrastructure in developed markets, and of technology disruptions in areas such as the Industrial Internet of Things (IIoT), automation, and artificial intelligence to break out of recent stagnation and drive the next phase of value expansion for its stakeholders?

Sidebar

Against this backdrop, we set out to better understand the forces at work. This effort resulted in a new report, Flow control—Sector at a crossroads? It provides an in-depth assessment of the sector’s performance over the past 15 years, the shifting dynamics affecting its future, and how the current playbooks will need to be adapted to capture future opportunities and drive the next phase of value expansion. The remainder of this article outlines some of our high-level findings. (For more on our research base, see sidebar, “Sector pulse check: Executive survey.”)

Historical performance in flow control

The industrials sector has demonstrated value-accretive growth through three distinct performance phases from 2002 to 2017: rapid growth, slump and recovery, and a dip and potential recovery. Throughout each phase, the flow control sector has outperformed the broader industrials sector and in 2017 had twice the economic profit as a share of revenue (EP/R) compared with industrials as a whole (3.0 percent versus 1.5 percent) (Exhibit 2).

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The consistent outperformance reflects the sector’s high gross margin—approximately 500 basis points (bps) higher than the average of broader industrials—and the fact that flow control products are highly specialized in nature, as many are engineered for specific or unique uses. In addition, flow control companies have established significant market share in small end markets, resulting in higher pricing power.

While flow control as a whole has notched strong performance on key economic indicators, there is significant variance in company performance within the segments (Exhibit 3). In fact, across the three segments, the EP/R performance gap between leading and trailing companies was between 1,300 and 1,800 bps.

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Our research shows companies in the top quartile comprehensively outperformed their peers on all output metrics:

  • higher revenue growth: 2.2 percent for the top quartile, versus –3.1 percent for their lowest-performing peers
  • higher earnings before interest, taxes, and amortization (EBITA): 23.3 percent versus 7.8 percent
  • better operating leverage: 18.4 percentage points versus –20.5 percentage points
  • higher capital turnover: 2.29 turns versus 1.73 turns

Interestingly, flow control company performance has not been static: 60 percent of companies moved across quartile rankings between 2002–07 and 2012–17. In that time frame, 30 percent of players moved up from a lower quartile; a similar amount were displaced from a higher quartile.

What made the difference for top-quartile companies? Analyzing company attributes and strategies, we found that neither a company’s starting size nor its capital expenditures had a major influence on its EP/R performance. Rather, our research indicates that companies that stayed in the top quartile or improved their performance over time did so by focusing on quality of revenue, innovating across three dimensions:

  • product: driving fundamental or core R&D, conducting frequent new product introduction, and rationalizing the portfolio
  • operational excellence: deploying capital to gain leadership, instilling process discipline in operations, and pushing innovation in operations
  • business model: building platforms and ecosystems to create recurring and “cost free” revenues and leveraging scale to drive customer value and capture a portion of it

Although the flow control sector has consistently outperformed the rest of industrials, performance has started to plateau as EP/R has flattened and fewer companies have secured positive economic profit. This trend is prevalent throughout the sector—top-quartile companies have seen their EP/R flatten, while the remaining companies have seen a decline in EP/R and, in the past two years, negative economic profit (Exhibit 4).

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In the past three years, we have also seen concentration in the sector, with only 35 percent of companies generating above-average economic profit, versus 45 percent of companies in the past. Thus, there are fewer winners and more are being left behind.

The outlook for the flow control sector

Still, the sector’s future continues to be bright. Prospects are driven by demand growth as global secular trends continue to create demand tailwinds for flow control equipment; moreover, the emergence of disruptive technologies can help companies innovate further.

Demand growth from secular trends

Our analysis suggests that the market will grow at approximately 4.0 percent per annum, compared with approximately 2.3 percent from 2012 to 2017. This will be driven by five global trends:

  1. Geographic trends. Rapid urbanization in developing economies is expected to increase the population of cities by 20 percent by 2025. This will have significant effects on infrastructure requirements in developing countries such as India and China and in regions such as Africa and Southeast Asia, creating geographic-expansion opportunities for flow control companies.
  2. Capital-expenditure outlook. In addition to increased spending on infrastructure in developing markets, infrastructure capital expenditures are expected to grow globally by approximately 3.2 percent, reaching nearly $10 trillion by 2022. Significant growth momentum is expected from investments in sectors such as water infrastructure and construction.
  3. Social trends. An aging population and aging workforce will create new skills gaps for companies, particularly in the oil and gas and power and utilities sectors, where hiring younger, digital-savvy workers is already a challenge. While automation will help companies address this skills gap, moving from manual processes to automation will require companies to invest in long-term solutions. Many flow control companies possess long-term domain knowledge and are critically involved in those end markets; they will therefore play a crucial role in this transition.
  4. Technology trends. Industry 4.0 and the IIoT have completely reshaped market expectations, vastly expanding the amount of connectivity and data the industry requires to make decisions and automate processes. As these technologies mature, the industrials sector and flow control companies have the potential to create new internal and external applications, and these applications will then enable new value creation.
  5. Geopolitical trends. Increasing sanctions and geopolitical tensions, as well as an escalating trade war and tariffs, will require companies to navigate new and frequently complex terrain, and to assess new opportunities as the industry landscape evolves. Further strain for flow control companies could be caused by a decrease in spending on infrastructure, slowing activity in construction, or another drop in oil and gas capital expenditures. Finally, an increasingly unpredictable political landscape will require players to aggressively maintain their competitive edge.

These five trends, on balance, will expand the total addressable market for flow control equipment and demand for specialized products and services.

Value generation from disruptive technologies

Disruption 2.0 technologies—such as artificial intelligence, machine learning, IIoT, autonomous driving, and blockchain—are expected to change how industries approach their operations and business models. This phase of disruption will be characterized by automated activities, a step change in productivity, and new types of interactions with machines. Disruption 2.0 technologies are creating opportunities for companies to improve the economics of their existing business as well as to secure substantial growth. Flow control companies could benefit as well if they adopt these technologies. Companies that embrace disruption and innovate in three dimensions—operations, product portfolios, and business models—could ultimately create higher-quality revenue and support the next phase of growth.

Companies that have already advanced on all three dimensions secured the highest quality of revenue and broke away from their peers by measures of financial performance. Progressing on all three dimensions is rare; most companies focus on one dimension to be recognized as an operations champion, product leader, or business-model innovator. The full report looks more deeply at what each type of company can do to excel.

What does it take to win?

The tailwinds driving the flow control sector will provide ample opportunity for companies equipped with the right enablers to outperform their peers and accrue value. However, companies that maintain the status quo will be left behind as the market changes. With innovation disrupting the sector, the old playbook will no longer suffice. Conversely, capturing value from these innovations will not be trivial. Going forward, companies must address four key imperatives to develop a winning strategy and scale up:

  1. Close the operating performance gap to free up capital. New technologies and solutions are critical to success in the new environment. However, technological development requires a significant investment in capabilities, infrastructure, change management, and talent. Flow control companies can free up cash for these investments by looking across the return-on-invested-capital (ROIC) tree for opportunities such as product portfolio and feature optimization, pricing, supply-chain optimization, and sourcing.
  2. Establish a pragmatic game plan to use disruptive technologies. Innovation can be expensive. Disruption 2.0 technologies can help flow control companies improve quality of revenue by focusing across the axes of product innovation, new business models, and operational excellence. However, the associated investments are significant. A pragmatic game plan is necessary to ensure the highest ROIC.
  3. Broaden the M&A mandate. Traditionally, M&A activities in flow control have focused on sector consolidation. For companies to pull ahead and capitalize on new trends and Disruption 2.0, they should broaden the focus of their M&A mandate to also fill gaps in technology and capabilities. M&A can provide a faster route to product-portfolio diversification, new business models, and technologies and capabilities such as advanced analytics.
  4. Establish robust governance and performance management. Closing operating-performance gaps and delivering on investments in innovation is a multiyear transformation. Such undertakings field a high risk of going directionless and compromising significant capital. As flow control companies embark on this journey, they should reflect on three questions: Have we defined appropriate near-term milestones that will help us gauge progress against the end-state objectives? Are we agile in our decision making so that we can reprioritize if our initial bets are not successful? Have we reserved sufficient senior-management attention to the cause?

Overall, flow control companies must keep pace with Industry 4.0, IIoT, and machine learning, and robustly engage with the changing demands of the global market. As innovation disrupts the sector, the old playbook will not suffice. Flow control companies that make the right moves stand to gain significant advantage in an exciting period of growth and disruption.

Download Flow control—Sector at a crossroads?, the full report on which this article is based (PDF–1MB).

About the author(s)

Stefanie Rühle is a specialist in McKinsey’s Munich office; Nick Santhanam is a senior partner in the Silicon Valley office, where Shekhar Varanasi is a partner; Akshay Sethi is an associate partner in the Chicago office; and Jannick Thomsen is a partner in the New York office.

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